WOW!!! Can anyone help with this? I am completely caught up in this arbitrage-free bond valuation junk. Does anyone know how to explain it in simplest terms, preferably with real examples? Any help would be appreciated.
Look. Wherever there is a mispricing of securities, there is an arbritrage opportunity. Now how does this mispricing take place? It is when we notice the individual interest rates upon each cash flow of a bond (each coupon payment till the principal payment at maturity). We think of each of these flows as individual bonds and sum them up to find whether the value you found is equal to the market price or not. If the value you came up with individual cash flow discounting is less than market price, then the bond is said to be undervalued. So you must buy the pieces (Treasury securities at their respective rates) and bundle them into ONE bond and sell it off as a bond to make profit out of such an arbitrage opportunity until the market price equals the value from discounting individual cash flows.
BTW - You need to figure out that “junk” because the “arbitrage-free” valuation of a coupon bond by dividing it into separate zero coupon bonds is the easiest problem in a huge set of problems like that.